Why the VAT Flat Rate Scheme Changes are Wrong.
In his September Autumn statement the Chancellor announced changes to the VAT Flat Rate Scheme designed to stop abusive avoidance. A few weeks before the Guardian had published an article on an employment agents direct tax avoidance scheme which also made use of the flat rate scheme. The changes were seen as an answer. See Guardian Article I believe these changes are either ill conceived or alternatively a well conceived but devious way of effectively abolishing a small business scheme.
The flat rate scheme was one of Gordon Brown’s ideas when he was Chancellor. Flat rate businesses still charge VAT on their sales and issue VAT invoices but instead of working out their VAT in the normal way and paying over the difference between the VAT they charge on sales and the VAT they have been charged on purchases, instead pay a fixed % of their turnover over to HMRC. They keep the difference between this amount and the amount of VAT they have invoiced. This difference can been seen as effectively an estimate of the VAT they have incurred on purchases, which they would have recovered under the normal VAT rules. The scheme is designed to stop businesses having such an administrative burden. A business with a turnover of below £150,000 can apply to use it.
When the scheme was first introduced it was not initially very popular. Ironically some in HMRC put the blame for its low take up on tax advisors who wanted to retain VAT compliance work. Certain changes were made and the popularity of the scheme has grown. This is partly because it’s easier for businesses as it avoids them needing to keep detailed purchase VAT records, but another reason is that businesses have realised that they will pay a lot less VAT. The reason for this is because the flat rates are set too low meaning businesses effectively get more estimated credit for purchase VAT than they actually incur. Since it’s a voluntary scheme businesses that lose from it will not apply to use it. Its hardly surprisingly therefore the businesses that use the scheme are generally better off under it.
The Flat Rate Scheme is perhaps rather like the controversial Northern Irish Fuel Scheme in that it has taken a while for people to realise that there’s a simple VAT saving to be had. But in using the scheme as it is designed are these businesses really engaged in abusive avoidance as contended by HMRC ? The answer is surely no. I rather suspect that HMRC is using the ‘anti avoidance’ argument as a smoke screen to disguise either their incompetence in setting the flat rates correctly or that the entire scheme was misconceived from the start. Ministers are being praised when in reality they should be censured.
To see how the scheme works lets consider a hypothetical business consultant with income just over the VAT registration limit. They have a VAT inclusive turnover of £100,000 a year but have relatively low costs – say £8,000 VAT inclusive. Only half of these costs bear VAT – they incur £666 VAT on hotel accommodation, some stationary and some online subscriptions. Under normal VAT accounting they would charge £16,666 Output VAT and recover £666 Input VAT, meaning they pay £16,000 to HMRC. For simplicity, assume they are on annual accounting and only complete one VAT return a year.
If our consultant instead used the Flat Rate Scheme they would pay a flat rate of 14% of their inclusive turnover – meaning they pay HMRC £14,000. This is £2,000 less tax than they would pay under the normal VAT accounting rules. Now this is clearly wrong and charges are needed but not what is being proposed.
The changes to the scheme introduce what can be seen as a ‘naughty tax avoider’ high flat rate of 16.5% which is triggered when the taxpayer is a ‘limited cost trader’. This is someone who spends less than 2% of their turnover, but at least £1,000 on non capital items goods. Petrol is excluded as are goods that have a mixed business/non business use.
Now although our consultant’s cost’s are 8% of their turnover, they mainly buy services and only spend £1,000 on goods – stationary, toner cartridges a few books. When the changes come in (1 April 2017) this means they spend less than the required £2,000 on goods and will be a reprehensible tax abusing ‘limited cost trader’. They will have to apply the 16.5% rate and pay £16,500 out of the £16,666 VAT they collect to HMRC. Their allowance for input tax will now be £166 which is £500 less than the VAT they actually incur. This 16.5 % flat rate is presumably set at this level to ensure that any limited cost business leaves the scheme and starts using the normal VAT rules again.
But will they. Our consultant gained £2,000 by applying the 14% flat rate scheme and can continue to do so if they spend an additional £1,000 on goods and stop being a limited cost trader. Even if they decided to spend £1,000 on wholly new, but arguably unnecessary expenditure such as printing a glossy brochure they would still be better off. In many cases they will be able to substitute goods for services. For example by using a physical rather than an online advertising campaign or buying physical copies of journals rather than online subscriptions. It would even pay them to shop around and buy the goods they do need from the most expensive supplier.
I would suggest that any tax change that creates such perverse incentives is misconceived.
The reason for the problem is that the new rule is an apparent anti avoidance provision that is triggered when a business fails to buy enough goods. I can’t personally see how buying an online subscription to a magazine rather than a physical one is the hall mark of a tax avoider but this appears to be the principle that the changes are based upon.
Why haven’t the Government just increased the flat rates to a more sensible amount. The rationale behind not doing this is presumably that only certain businesses are abusing the scheme by gaining an advantage and for the majority of businesses the flat rates are correct. ie there are what one might term abnormal outliers and when they are removed the scheme will work again. But for some sectors certainly this just can’t be true.
The flat rate scheme has a great many different flat rates. For example there are rates for Book Keepers (14.5); Dog Walkers (12%); Pet Coat Clippers (12%); Authors (12.5%); Dance Instructors (12.5%) and Entertainers (12.5) %. Now I would suggest that all these businesses generally spend far less than 2% of their turnover on non capital goods, excluding petrol and goods with mixed private/business use. I mean what exclusive business goods does an author need, a couple of pencils and the odd printer cartridge – this is unlikely to be over £1,000 which is the minimum goods purchase they must make to avoid the infamy of being a limited cost trader. The proposed charge will mean that average businesses in these sectors will be hit by an anti avoidance rule for being – well normal.
What the changes are doing is effectively withdrawing the flat rate scheme from certain types of business by making it unattractive. For these it is not a true anti avoidance measure but the disguised withdrawal of a small business simplification scheme.
Even if this is not true of all sectors and there are some where the existing flat rate is correct for the majority of users; attempting to identify the outliers by mean of a test as clumsy and open to manipulation as the value of purchased goods is wrong. Certain types of business are more dependent upon physical goods than others and all are becoming less dependent on goods as a result of technological change. Why should a service dependent business be put in a worse position than a goods based one. Changing the proposed provision so that services are also included would be a lot more equitable and still catch genuine ‘low cost’ traders. But it would of course mean that our fairly normal consultant continues to use the scheme and maybe the hidden agenda behind the change is to ensure that they stop.
For most sectors surely the obvious thing for HMRC to have done would have been to admit the flat rates were too low and increase them. But perhaps this would have been too embarrassing as it would have implied that a mistake had been made in setting the flat rates to start with or that the survey information they are based upon was wrong. It’s far easier and more praise worthy to blame businesses for taking advantage of a tax give away than accept you were wrong in offering the give away in the first place.
I confess I have never liked the Flat Rate Scheme as it appears to be an attempt to simplify VAT by removing its essential mechanism which is the credit for taxable costs. Now it might be the case that certain types of business are too diverse for it ever to be possible to set a single flat rate, meaning for these businesses the scheme can never work effectively. If this is true then HMRC should provide the evidence and then withdraw the scheme from these sectors. They shouldn’t withdraw it by stealth behind the cover of an anti avoidance measure.
HMRC have asked for submissions on implementing the measures. Lets hope for some changes or better still a complete rethink. See HMRC Note on Changes